Identifying Proceeds with Blockchain: A Solution to the UCC § 9-315(a) Problem of Proof

Brittany J. Foster, KLJ Staff Editor[1]

Banks have built a reputation for being “anti-bitcoin” in recent history, but their interest in the underlying blockchain technology which supports the transfer of bitcoin and other digital currencies has been at an all time high.[2] Banks have embraced the idea of blockchain for good reason. It has the potential to greatly simplify expensive processes—specifically the process of tracking currency flow. Blockchain is a decentralized open ledger which is integrated across a peer-to-peer network of computers, and essentially works as follows:

The ledger permanently records changes to the database using cryptographic hash-linked “blocks.” When a transaction occurs, a block is added to the ledger, forming a sequential chain with previous transactions, thus the name blockchain. Each block contains data from the previous block, so each transaction can be validated by computers and viewed and affirmed by consensus among the participants in the network. No single party controls the data or the information. Every party can verify the records on the ledger directly, without reliance on any central authority.[3]

This process creates an incredibly secure ledger which is virtually “hack” proof, making it ideal for big banks, since one would have to hack every system the ledger occurs on and make specific changes in each one to perform a successful hack.[4]

Blockchain may be able to benefit banks and other lenders in numerous ways, but specifically in the realm of secured transactions. In secured transactions, problems often arise when a security holder tries to obtain proceeds from a debtor’s disposition of collateral. Security holders must wrestle with the difficulty of tracking proceeds once assets have been comingled. In such situations, it may be impossible to figure out which funds in an account proceeded from secured collateral and which funds came from elsewhere. Many times, this creates an impossible hurdle for security holders to overcome because the UCC only permits security holders to obtain the proceeds from disposition of collateral if those proceeds are identifiable.[5]

A prime example of the proceed tracking problem can be found in In re Oriental Rug Warehouse Club, Inc., in which case, the defendant purchased rugs from the plaintiff and promised to pay the plaintiff back with any proceeds from the sale thereof.[6] However, the defendant used the proceeds to invest in more rugs for his inventory and thereafter filed bankruptcy.[7] Afterwards, the plaintiff claimed a security interest in the rugs purchased with proceed money.[8] The court held that unless the plaintiff could prove that the proceeds came directly from the sale of the rugs, he could not claim a security interest in the later purchased rugs. Of course, the plaintiff could not identify the proceeds with certainty since cash purchases are often impossible to track.[9]

Blockchain may be a clear solution to this proceed tracking problem. If proceeds from collateral are documented on a blockchain ledger then the tracking process is substantially simplified. Blockchain would eliminate the necessity for expensive investigation relating to the source of assets because the history of those assets would be identifiable in an open ledger for the world to see.

If security holders initially contract for any proceeds from collateral to be tracked and processed via blockchain then cases like In Re Oriental Rug could likely be decided on summary judgement since the security holder would be able to show a direct link between secured collateral and cash in the debtor’s account or cash used to purchase new inventory. To that end, debtor’s may be less likely to even contest the issue of proceeds if they know every transaction related to the collateral is traceable in an open ledger. Such a transparent environment could eliminate the need for litigation over tracing proceeds entirely, making blockchain a clear choice for proceed tracking in secured lending.

[1] J.D. expected May 2019.

[2] Tim Culpan, Blockchain ≠ Bitcoin: There’s no conflict between denouncing the cryptocurrency and embracing the technology that supports it, Bloomberg (Nov.‎ ‎7‎, ‎2017‎ ‎11‎:‎34‎ ‎PM‎), https://www.bloomberg.com/gadfly/articles/2017-11-08/blockchain-bitcoin.

[3] Laura E. Jehl, An Introduction to Blockchain Technology, Bloomberg Law Tech & Telecom, https://www.bakerlaw.com/webfiles/Privacy/2017/Articles/11-2017-Jehl-BNA-Blockchain.pdf, (last visited Feb. 18, 2018).

[4] Id.

[5] U.C.C. § 9-315.

[6] In re Oriental Rug Warehouse Club, Inc., 205 B.R. 407, 409 (Bankr. D. Minn. 1997).

[7] Id.

[8] Id.

[9] Id. at 411.

*Image licensed in the Public Domain, pursuant to CC0